Inherited Retirement Accounts and the Beneficiary’s Tax Consequences

When the owner of a retirement account – a 401(k) or a traditional or Roth IRA – passes away, the account’s transfer to the designated beneficiary raises tax issues for the beneficiary. The nature and extent of those tax issues depends largely on the beneficiary’s relationship to the deceased, i.e., whether they are:

• a surviving spouse (and a few others, described below); or
• a non-spouse beneficiary (including an adult child).

For a surviving spouse, the tax-planning impacts are relatively mild. They can generally roll their deceased spouse’s account proceeds into their own IRA; by rolling it over, they can treat the account as their own, deferring any “Required Minimum Distributions” (RMDs) until they reach the IRS-mandated age (currently 73, and increasing to 75 for those born in 1960 or later).

Conversely, non-spouse beneficiaries are subject to what is known as the “10-year rule” (see details on the IRS website), and understanding the applicable variables is essential to avoiding serious tax consequences.

Inheriting a Retirement Account – in General

The 10-year rule holds that non-spouse beneficiaries (with a few exceptions noted below) must generally withdraw all funds from the account within 10 years of the account holder’s death. However, whether annual RMDs are required during those 10 years depends entirely on whether the original account owner died before or after their “Required Beginning Date” (RBD).

(Note: If a retirement account is “non-designated” – i.e., is designated to go to an estate or an improperly drafted trust – and the account owner died before their RBD, then the 10-year rule can shrink to five years. The “5-year rule,” which applies when there is no designated beneficiary, makes it important to name a specific person as the beneficiary of the account.)

In handling the inherited account, a non-spouse beneficiary generally must:

• open a new, separate account in their name to receive the inherited funds; and
• decide whether to take a lump-sum withdrawal (which would be subject to income taxation for the year in which it’s taken) or manage the funds over the 10-year period.

The SECURE Act of 2019 created the 10-year rule. IRS regulations finalized in 2024 clarified that annual RMDs are required only if the original owner died on or after their RBD. The penalty for failing to take a required RMD is 25%, which can be reduced to 10% if corrected within two years.

The Fine Print

Whether a non-spouse beneficiary has to take annual distributions, in addition to withdrawing all the funds within 10 years, is very fact-specific with regard to the decedent’s date of death and the beneficiary’s situation.

Did the account owner die before they reached their RBD? If yes, the beneficiary:

• will be subject to the 10-year rule; and
• no annual RMDs are required during the 10-year period.

Did the account owner die  after their RBD?   Generally, their required beginning date was April 1 after the calendar year in which they reached age 73. If they passed away after reaching their required beginning date, the beneficiary:

• will be subject to the 10-year rule, and
• must take annual RMDs each year during that 10-year period.

For deaths in 2020-2023, the IRS delayed enforcement of missed annual RMD penalties due to regulatory uncertainty. For deaths in 2024 and later, the above rules apply fully.

Are you eligible for an exception?  A non-spouse beneficiary may qualify for the same RMD treatment as the account holder’s spouse if that beneficiary meets the criteria for an “eligible designated beneficiary” (EDB) – mainly, a beneficiary who has disabilities, is chronically ill, is 10 or fewer years younger than the account owner, or is a minor child of the account owner.

A qualifying EDB may take distributions gradually each year, based on their life expectancy, and is not required to empty the account within 10 years unless they lose EDB status (e.g., a minor child reaching the age of majority).

Seek Professional Help

Even in this relatively simplified look at inherited retirement accounts, you can see how tax outcomes depend heavily on the decedent’s RBD status, the beneficiary’s classification, and whether the account is a traditional or Roth IRA.

To gain a clearer understanding of how inheriting a 401(k) or IRA could affect your planning and taxes in the years to come, ask your attorney or tax advisor to help you prepare an effective strategy.